Archive for February, 2007

Interest rates in Japan had been zero for many years. It was only until recently that it had risen to only 0.25%. Such an unusual financial phenomenon sparked an interesting money-making opportunity?the yen carry trade. Basically, in a yen carry trade, you borrow money in Japan (where the interest rate was zero and is now 0.25%) and lend in countries with much higher interest rates. The interest rates differential makes up your profit. There are many ways to play with the yen carry trade. The most conservative way is to invest the borrowed money in US Treasuries. No doubt, there will be some hedge funds who want to achieve higher but more risky returns by investing in more risky assets such as stocks and Shanghai real estate.

What is the risk with this kind of strategy? Well, this strategy counts on the exchange-rate of yen not rising. A rising yen can wipe out your interest rates differential profits, even possible resulting in losses. Thus, the next crucial question is: what can result in an appreciation of the yen? For 16 years, Japan lived under the threat of deflation and economic malaise?that is the reason why the Japanese central bank made its money as cheap as possible (i.e. zero interest rate) in an attempt to counter such an economic threat. It is only until recently that the first lights of economic recovery can be seen. At this point in time, the Japanese economy is still dependent on exports to grow, which means that they have an interest to keep the value of yen low.

What will happen if the Japanese economy finally makes a confirmed recovery back into normality (there are signs that the Japanese economy may be recovering?read this report)? We can bet that Japanese interest rates will rise, thus putting a squeeze in the carry trade profit margins. More importantly, it means that the Japanese are finally willing to allow their yen to appreciate. Any appreciation of the yen will result in massive reversal of the yen carry trade, which in turn will trigger further appreciation of the yen, resulting in a self-reinforcing feedback loop. The danger right now is that a massive amount of yen are being borrowed (some experts says it is worth a trillion dollars), which in effect is a gigantic bet that the yen will not rise. A disorderly reversal of the yen carry trade will almost certainly mean that there will be losses in terms of billions of dollars, triggering yet another financial crisis. We will then see the collapse of many hedge funds.

Back in Awash with cash?what to do with it?, we mentioned that the US has been running current account deficit for many years. In layman?s terms, it means that the US is spending more than it earns, resulting in the net outflow of US dollars to foreigners. Countries like China, Japan and the oil-producing nations are sitting on such a large pile of US dollars that they do not really know what to do with them.

Generally, these surplus US dollars will not be very useful outside the US. Eventually they will have to be recycled back into the US in the form of purchases of US assets (e.g. stocks, bonds, properties, businesses, etc). Such recycling of US dollars makes up the capital account in the balance of payment. A positive capital inflow means that foreigners are buying up more US assets. Thus, when we say that the US is ?borrowing? from foreigners to fund its spending, it means that current account deficit is financed by the capital account surplus. In theory, these two accounts should be identical as they are just an accounting offset of each other.

As we all know, the US current account deficit hits another record high in 2006 (see U.S. Trade Deficit Grew to Another Record in ?06). As such, in theory, there should not be a net capital outflow. At this point in time, it is not clear whether this is the beginning of a trend. If so, it can only mean one thing: foreigners are no longer willing to extend credit to the US. When that happens, we can expect the US dollar to fall precipitously along with an epic financial crisis.

Recently, this news report came up in CNN: Lawmaker: U.S. sent giant pallets of cash into Iraq. In this report, 363 tons of cash (worth $4 billion) were loaded into pallets and transported via military transport aircraft into Iraq ?shortly before the United States gave control back to Iraqis.? Needless to say, much of the cash went unaccounted for.

As we said before in A brief history of money and its breakdown- Part 2, when much of the world was under the gold monetary standard, nations only go off that standard under exceptional circumstances, such as war. This is because war is always prohibitively expensive and thus, can only be financed if fiat money is used. Today, we look with disbelief at such a gross abuse!

Back in Liquidity?Global Markets Face `Severe Correction,? Faber Says, we mentioned that when money is ‘created’, the ?outcome is a pyramid of ?money,? with hard cash at the apex and derivatives at the bottom.? Imagine what this $4 billion of cold hard cash is eventually going to do to global liquidity! To see what will become of these monies, let us examine how this massive quantity of physical cash is going to swell the total money supply, which includes bank deposits. Today, we live in a time of fractional reserve banking system. Put it simply, if you deposit $100 into a bank account, the bank is going to lend out a large proportion of your $100 and keep the rest as reserves, in case you decide to withdraw some of your money as cash. The proportion that the bank is going to keep as reserves is the reserve ratio. Let’s say the reserve ratio is 10%. After depositing $100, the bank is going to keep $10 and lend out $90. The $90 that someone borrowed from the bank will again be deposited, resulting in $81 being lent out and $9 keep as reserve. At this point time, how much money has you original $100 multiplied into? In terms of the amount of bank deposits, there are now $100 + $90 + $81 = $271 of ?money? in the financial system. This can go on and on, until the quantity of money swell to the theoretical limit of $1000 (based on reserve ratio of 10%). Thus, for example, a ratio of 5% can swell the quantity of money up to the theoretical limit of 20 times.

The next question is: what is the reserve ratio? We took a look at the Federal Reserve?s requirements on reserve here. Depending on the amount on deposit, the ratio ranges from 0% to 10% (a ratio of 0% means that money can be created by the banks to a theoretical limit of infinity). Anyway, whatever the answer to this question, $4 billion of physical cash will eventually spawn many more times worth of liquidity into the financial system. It certainly would not help in the ?fight? against inflation.

Today, we heard an interview on Sol Trujillo, the Managing Director of Telstra, on the Eureka Report podcast. In the interview, Sol was asked what will be the main drivers of revenue for Telstra in 2010.

Sol replied, ?By 2010, Telstra wouldn?t any longer be called just a telecom business. It?s going to be a media-comms business, which means our revenue profile [will] change.? He then went on to explain that revenue streams from Telstra’s traditional telephone services (PSTN) will decline, while other revenue streams will gain in prominence. Growth areas include wireless Internet broadband (NextG), mobile phone services, media content (Foxtel) and online and print directory services (Sensis). Furthermore, Telstra is expanding overseas, buying an online real estate business in China, which Sol affirmed that it was ?growing at triple digits? as the Chinese real-estate market is rising exponentially.

Will Telstra remain just a telecommunication company in the future? This is a very interesting question. If the answer is ?yes?, we would not be keen in investing in Telstra because there are much more lucrative opportunities elsewhere. We suspect the answer will be ?no? because if we were Sol Trujillo, we would have taken the strategic path to transform Telstra to one that is more than a telecommunication company. We believe this strategy is the key to Telstra?s future.

One of the pre-requisite skills of an atypically excellent investor is the possession of entrepreneurial foresight. Entrepreneurs see the future creatively and understand the big picture. If you can see the future through the eyes of an entrepreneur, it will lead you to today?s small businesses that may be on the way to become big businesses of the future. If you invest in such small businesses today, your returns can multiply in terms of hundreds and thousands of percent. Of course, such investments are not without risks. What separates the best investors and the mediocre ones are how they deal with risks. For the excellent investors, they mitigate risks with knowledge, understanding and skill. For the average investors, they mitigate risks with wholesale diversification.

Stock analysts, by definition, are usually not entrepreneurs. The dichotomy between their analysis and entrepreneurs? foresight is illustrated by Sol?s comment in this article, Hurdles, but Trujillo’s Telstra a winner:

Trujillo opened up on the sort of long-term group returns he is aiming at when I pointed out that most of the analysts say that Telstra will generate big future cash flows but not substantial profit rises. “Yeah, well, the analysts here in Australia that have written about Telstra have been absolutely wrong almost across the board,” he says. “Look back at what they said in November 2005 and what has happened since then. So that’s why some people are analysts and why some people are managers and leaders.

We guess many stock analysts will be insulted by Sol?s comments. By insults aside, let us see why analysts are often ?wrong.?

We believe the reason is in the difference between the thinking of analysts and entrepreneurs. Analysts, by definition of their job description, look at businesses through the eyes of the status quo. Yes, they may engage in the forecast of future earnings of a business, but their forecasts are usually made by extrapolating from the status quo or some other derivations from it. Entrepreneurs, on the other hand, look at businesses from the eyes of what can possibly be in the future. As such, what others see as ?impossible? is an opportunity for entrepreneurs to force the camel through the eye of the needle.

Thus, we would not go as far as to say that analysts are ?wrong? as Sol had done. The job of analysts is to base their analysis on what is already solid and ?proven,? which is usually what the eye can see as the current state of affairs. But the job of entrepreneurs is to take risks and turn the current order of things upside down and sweep the status quo aside. With luck, determination and skill, entrepreneurs may succeed. Or they may fail.

As investors, we rather go along with the entrepreneurs and try to understand the risks they take instead of shying away from them by diversifying and diluting our investments.

In our previous article, The first step in an economic slowdown?mal-investment in capital, we mentioned that one of the causes for slowdowns in the business cycle is the presence of mal-investments. Mal-investments will eventually have to be liquidated, resulting in a cyclical slowdown of the economy. In that article, we discussed about the structure of capital, which gives rise to the concept of mal-investments, which is unique to the Austrian School of economics. It should be emphasised that unlike other schools of economics, the Austrian School makes a distinction between overinvestment and mal-investment. It is the latter that is of primary concern in Austrian theory. Today, we will look at a real-life example of mal-investments and its effects.

During the dot-com bubble of 1996-2000, the NASDAQ flew from around 1000 to around 5000. Credit for ?investments? were abundant and plentiful. Any stocks related to the Internet were soaring well beyond its fundamentals. Spending on IT projects were mushrooming up everywhere; loss-making dot-com companies were floated; consumer spending, which were fuelled by the monetary print press (and not from sound savings), remained strong; Real-estates in the Silicon Valley sky-rocketed. Indeed, IT investments were running very high.

This is an example of a mal-investment.

Entrepreneurs, as a whole, invested as if all capital goods will be available at their disposal to ensure the success of all their plans. From the hindsight of today, it is clear that this was not true?there were shortages of programmers, network engineers, and technical managers. We recalled the days when a fresh IT graduate, who hardly had any experience and skills on the latest technologies, could fetch a salary of more than AU$50,000! Consequently, all the idealism of wealth through technology crumbled when reality sets in. As many IT start-up companies realised, the cost of staying in business was so prohibitive that eventually, a large number of them had to be liquidated. Today, only a few survivors remained alive. The resulting deflation of the bubble led to a recession (albeit the mildest one ever).

In our previous article, The real story behind the phenomena of booms and busts, we mentioned that when the central bank finally raise interest rates, the economy will slow down as ?entrepreneurs will slow down their rate of investments, which means that employees will be laid off, projects cancelled, and cost being cut.?

Why would entrepreneurs have to slow down their rate of investments, which result in an economic slowdown? To answer this question, we have to understand that capital can be mal-invested. The reason why capital can be mal-invested is because it has structure, which is one of the key insights of the Austrian School which is not found in other school of economics.

What is the structure of capital?

Recall that in The myth of financial asset ?investments? as savings, we mentioned that capital goods are ?goods that help in the production of consumer goods?they increase the future productive capacity of the economy.? Capital goods that are directly used in the production of consumer goods are termed ?first-order? capital goods. An example of a first-order capital good is a sewing machine that is used to produce clothing for consumers. Capital goods that are used in the production of first-order capital goods are called ?second-order? capital goods. An example of a second-order capital good is the robot that put together the sewing machines in the assembly line. The third-order capital good are then used in the production of second-order capital goods and so on. Thus, capital goods can be arranged from the first-order up to the higher orders?this is the vertical structure of capital. Capital can also have horizontal structure. Some capital goods are complementary to other capital goods in the production of other goods. For example, computer software and hardware are complementary capital goods. In reality, the capital structure can be more complex?capital goods can play different roles in the horizontal and vertical chains simultaneously and may perhaps function as a consumer good at the same time.

It is customary to describe the boom as overinvestment. However, additional investment is only possible to the extent that there is an additional supply of capital goods available. As, apart from forced saving, the boom itself does not result in a restriction but rather in an increase in consumption, it does not procure more capital goods for new investment. The essence of the credit-expansion boom is not overinvestment, but investment in wrong lines, i.e., malinvestment. The entrepreneurs employ the available supply of r + p1 + p2 as if they were in a position to employ a supply of r + p1 + p2 + p3 + p4. They embark upon an expansion of investment on a scale for which the capital goods available do not suffice. Their projects are unrealizable on account of the insufficient supply of capital goods. They must fail sooner or later. The unavoidable end of the credit expansion makes the faults committed visible.

Now, we return to our original question: why do entrepreneurs have to slow down their rate of investments? Based on our new understanding capital structure, it is more accurate to say that entrepreneurs not only have to merely slow down their rate of investments, they may even have to liquidate their investments due to their errors in judgements. As the economy booms, entrepreneurs make plans and invest in the belief that the economy’s capital structure will provide the necessary higher-order and complementary capitals in the future. What happens when capital are mal-invested, leading to an unbalanced structure of capital in the economy? The entrepreneurs’ plans will fail, which mean they will have to liquidate their investments. When that happens en masse, it will result in what we see as layoffs, cancelled projects and so on.

In our last article, Where are we in the business cycle?, we mentioned that we are now probably at the peak of the business cycle. Given that this is the case, how should that affect our investment decisions?

When the economy is in the doldrums, the professional money manager begins to think about investing in the cyclicals. The rise and fall of the aluminiums, steels, paper producers, auto manufacturers, chemicals, and airlines from boom to recession and back again is a well-known pattern, as reliable as the seasons.

Therefore, cyclical stocks are the ones in which their earnings follow along with the peaks and troughs of the business cycle.

One of the common mistakes that novice investors often make is to extrapolate the past earnings of cyclical stocks into the indefinite future during the turning points of the business cycle. Since the stock market always anticipates the future earnings of companies, cyclical companies will look ?cheap? (i.e. low P/E ratio) during the peak of the boom. This is because the market will have by then factored in the fall in earnings. The key is to identify which types of businesses are cyclical in nature and avoid them during the peaks? turning point. As Peter Lynch said:

When the P/E ratios of cyclical companies are very low, it?s usually a sign that they are at the end of a prosperous interlude. Unwary investors are holding on to their cyclicals because business is still good and the companies continue to show high earnings, but this will soon change. Smart investors are already selling their shares to avoid the rush.

In Australia, the economy has been expanding for the past 16 years already. This current expansion is twice as long as the previous two expansions. Thus, it is very easy for investors to believe that business cycles no longer apply and become complacent as a result. When we see that the stock market is continuously making record highs, as if the boom time will still continue indefinitely, it is time to become wary.

Demand in some sectors has been especially strong over a number of years, reflecting the growth of the domestic and international economies. If firms cannot bring new factories or mines immediately on line when capacity constraints become binding, they may decide to hire more labour to work their existing production processes more intensively. This would lead to strong employment growth, but also a fall in the growth rate of average labour productivity because only relatively modest additional output can be produced by hiring more labour without additional capital.

To cope with the strong demand, businesses are forced to increase output. Unfortunately, the effectiveness of the existing capital stocks in the economy is reaching its limit and the only way to increase production further is to employ more labour and pressure the existing employed workers to produce more. As the statement says, without complementary capital, these extra labours are constrained in its effectiveness in increasing output.

Recently, we read in this news report, Consumer confidence ‘lowest since 2003′, ?dragging sentiment down in the half was a sharp 14 point fall in the quality of life rating to 25.5 points… But (they are) finding it more difficult to achieve due to the demand for longer working hours and more intense competition in the job market.? Anecdotally, many of us are feeling the increasing strain of work. Though Australia may be experiencing the lowest unemployment rate, it comes with a cost at our quality of life. Worse still, according to our personal experience, we can feel that price inflation is more pronounced lately.

With the economy struggling to increase output and the money supply still growing, we can expect price inflation to still remain a threat. But price inflation has been quite benign during the past few years. Why is it so? As in the United States, price inflation has been ?controlled? by importing of goods from China. As we said in The Bubble Economy, the rise of the Chinese economy?s productive capacity has a disinflationary effect on prices worldwide. But such low inflation can only be achieved at the cost of incurring a ballooning trade deficit?our imports exceeding our exports. But make no mistake about it: we cannot always rely on the Chinese to save us from price inflation by blowing out our current account deficit even further. So, the greatest danger to Australia?s economy right now is price inflation. As we said in The real story behind the phenomena of booms and busts, if interest rates persistently remain out of sync from the natural rate of interest for too long, we can run into the danger of hyperinflation.

How can we restore the economy back to equilibrium and ensure that it remains in a firm footing for the future?

The first thing that has to happen is to increase our national savings. As we said in The myth of financial asset ?investments? as savings, we need to restore and rebuild our stock of capital goods to ensure our future prosperity. Already, the quality of our education, health, telecommunication and transport infrastructures are in decline and they are in need of repair and upgrade. This means that the only way we are going to achieve that is to reduce our current consumptions and cut down our debt. When that happens, the economy will slow down and many businesses and investments will fail as a result. Since most of the Australian (and the US as well) is made up of consumer spending, in which much of it is funded by debt, we can see that this remedy will be painful. If the consumers do not slow down and get their act together, we can expect the RBA to impose a restraint by raising interest rates.

Thus, we believe that Australia (and the US as well) is at the top of the business cycle. For investors, we have to bear in mind that we are now probably at the cyclical top. If we assume that the current trend of companies? profit growth will extend indefinitely into the future, we will be in for a nasty surprise.

First, we revisit the thought-provoking question that we first asked in What cause booms and busts? Introduction to the Austrian Business Cycle Theory: How can the central bank know the ?right? price of money when it decides the level of interest rates? The truth is, it does not and the outcome is less than ideal as it sets interest rates at levels other than ones the free market would have chosen.

Let us suppose that interest rates are decided by market forces. How would it be decided? As expected, the fundamental economic law of supply and demand determines the level of interest rates. As consumers seek to defer their consumption to the future, they increase their savings rate. This increase in the supply of money from savings pushes down the interest rates. Conversely, as consumers seek to increase their current consumption at the expense of the future, they decrease their savings rate, which decrease the supply of money for savings, which in turn pushes up interest rates. On the side of the entrepreneurs, their demand of capital, which is supplied from the consumers’ savings, will lead to an equilibrium level where supply equals demand. This equilibrium level is the natural rate of interests.

Now, what happens if the central bank interferes with market forces and set the interest rates below the natural rate? The outcome would be that the demand for capital (from entrepreneurs) will exceed the supply of capital (from consumers). The only way to bridge this gap would be to increase the supply of money (that is, ‘printing’ of money). When that happens, through the fractional reserve banking system, the amount of credit in the financial system will be increased multi-fold. Consumers will spend more than they would have if the interest rates had been higher. Entrepreneurs would invest more than they would have if the interest rates had been higher. The outcome would be ‘greater’ economic activity.

But there is one problem with this state of affairs?there are finite amount of resources for the economy to work on in order to keep up the rate of production with the increased investment and consumer demands. Thus, for a time, the economy can be stressed to increase its rate of production, but ultimately, it will meet its limit. At this point in time, the boom part of the business cycle is coming to a halt. This is what is happening to Australia right now as the Reserve Bank increasingly uses the phrase “capacity constraint” to describe the economic situation.

If the interest rates are still kept artificially below the natural rate, the outcome will be price inflation as the artificially induced demand far outstrips the economy’s capacity to produce. If left unchecked, the result will be hyperinflation. Thus, the central bank will have to raise interest rates to curb the excess demand. Consumers will cut their consumption as their debt becomes more expensive. Entrepreneurs will slow down their rate of investments, which means that employees will be laid off, projects cancelled, and cost being cut. At this point, we have come to the bust part of the business cycle.

Thus, the adjustment of interest rates by the central bank does not ?smooth out? the peaks and troughs of the business cycle. Instead, such interference of the interest rates is the cause of the business cycle.

As we all know, since we live in a world of scarcity, the economy has a finite amount of resources (e.g. land, capital, labour, technology, raw materials, etc) to produce the goods and services that consumers want. Thus, the gas in the bus represents all the available finite resources in the economy.

The economy is always producing goods and services. Thus, the trip across the desert represents a period of time of economic activity.

In any economy, there is a class of people called the ?entrepreneur.? They are the business people who take risks by anticipating what consumers may want in the future and create the products and services that meet these anticipated needs. A very good example of an entrepreneur is Henry Ford who introduced the motor car to the world. In the metaphor, you, the bus driver, represent the entrepreneurs in the economy.

Then there is a class of people called the ?consumers.? Basically, consumers enjoy the fruits of the economy?s production of goods and services?they ?consume? resources of the economy. The passengers in the metaphor represent the consumers of the economy. As we said before in The myth of financial asset ?investments? as savings, there is a need to make a choice ?between producing consumer goods for current consumption or capital goods which will help in producing future consumer goods.? In the metaphor, the choice to use how much air-conditioning for comfort represents the choice of the consumers in how much they want to consume now at the expense of saving for future consumption.

In the economy, the entrepreneurs will borrow capital to engage in investment spending in order to fulfil what the consumers may want or need in the future. The speed of the bus represents the amount of investment spending to undertake.

Finally, the bogey man who tampered with the passengers? survey results is the central bank, which sets the interest rates. Please note that we are not accusing the central banks of any misconduct?they happened to fit the villain in our choice of metaphor.

So, how do all these fit into the explanation of the business cycle? Stay tuned!